Q&A
Explore Your Options
| Got a question about options? Tom Gentile
is the chief options strategist at Optionetics (www.optionetics.com), an
education and publishing firm dedicated to teaching investors how to minimize
their risk while maximizing profits using options. To submit a question,
post it on the STOCKS & COMMODITIES website Message-Boards.
Answers will be posted there, and selected questions will appear in future
issues of S&C. |
Tom Gentile of Optionetics |
COLLAR QUESTIONS
I need help understanding collars. I know you sell the call to finance
the put, and the put options act as insurance on your stock. But
what happens if your stock takes off and you are assigned the call? Would
you forfeit profits on the stock if it takes a run up? Is there a way around
this?
As you stated, the collar is a position created with long stock, a short
call, and a protective put. By "long stock," I mean holding shares. It
could be a new purchase of stock or an existing position. The collar also
includes a put, which will protect the stock from a move to the downside.
A long stock, long put position is sometimes called a "protective put."
One put option is purchased for every 100 shares of stock. However, the
collar is different from the protective put because it includes a short
call. Selling a call will bring in premium, which helps pay for the put.
One call is sold for every 100 shares of stock. So the collar is a low-cost
way of protecting a stock position.
But as you noted, the short call will limit the possible gains from
the stock if the stock moves higher. Why? Because if the stock moves above
the strike price of the call, the option will probably be exercised and
the stock called away. If the stock is purchased for $51.50 and the short
call has a strike of $55, the stock will probably be called away from the
owner if the stock rises above $55 a share at or near expiration. Unless
the call is bought before it is assigned, there is no way around this with
a regular collar.
However, a variety of collar strategies can help. For example, selling
out-of-the-money? (OTM) calls to pay for at-the-money? (ATM) puts will
lessen the probability of the stock being called away. In the previous
example, buying the 50 puts and selling the 60 calls will decrease the
odds of having the stock called away. The trick is to find OTM calls that
have high-enough premiums to pay for ATM puts. They are out there, usually
with longer-term options.
CLOSING A CALL RATIO BACKSPREAD
I have a question about exiting the trade. Say I bought two contracts
and sold one for credit or even. The stock price movement is then in my
favor and close to expiration date. If I want to exit the trade, do I sell
only one of the two contracts and let the sold contract expire? Or do I
close the trade by selling what I bought and buying what I sold?
A call ratio backspread is a strategy used when the strategist expects
a bullish move, but wants to limit losses in case the stock moves south.
The trade is created by selling ATM or near-the-money calls and buying
a greater number of OTM calls. The ratio is generally two calls bought
for every one sold or three calls bought for every two sold. Ratios will
also vary based on the trader's objectives and time frames. However, 1
x 2 and 2 x 3 are common ratios.
The trade delivers profits if the stock moves higher and the long calls
appreciate in value. However, the short calls help pay for the cost of
the long calls. In many cases, the premium from the short calls may be
greater than the cost of the long calls. If so, the trade is created for
a credit-that is, the strategist receives premium for establishing the
trade. If the stock tanks, all of the calls expire worthless and the trader
keeps the credit, which results in a profit.
However, greater profits are possible if the stock moves higher and
the calls in the backspread gain value. At that point, the trader will
exit the trade, which is done by reversing the position. Buying back what
you sold and selling what you bought will close the trade. Selling only
one of the two long call options changes the trade from a call ratio backspread
(bullish) to a bear call spread (bearish). This can be done if the outlook
for the stock has changed, but it does not close out the position. To exit
the trade, the two long calls are sold and the one short call bought back.
VOLATILITY QUESTION
How do we know if an option is low or high volatility? If the volatility
is low, what is the arbitrary number we should look for?
Each options contract will have a unique level of implied volatility
[IV]. This level of volatility is really a measure of volatility that is
priced into the options premium. It is computed using an options pricing
formula like the Black-Scholes? model. However, most options traders today
don't do the math or use the formula. Instead, IV information is available
through data services and brokerage firms.
Basically, what IV reflects are expectations about the level of volatility
of the stock, future, or index. It is sometimes called expected volatility.
If, for instance, the implied volatility of XYZ options is high, it indicates
the market, or the majority of investors, expects XYZ to exhibit high levels
of volatility. In that case, implied volatility and the option premiums
will be higher. However, if ZYX options have low implied volatility, it
suggests that ZYX is expected to exhibit low volatility levels. When IV
is low, option premiums are also lower.
So how do we know if implied volatility is high or low? Each individual
stock, index, or futures contract must be considered separately. The implied
volatility of options on the Dow Jones Utility Index ($DUX) will be lower
than the IV on options on a biotechnology stock like IMCLone Systems (IMCL)
because the former is less likely to exhibit volatility.
Options traders want to consider implied volatility of each individual
contract and compare current levels to the past. To determine if IMCL options
have high or low implied volatility, it makes sense to compare the current
IV levels to those during the past three, six, or 12 months. Some data
services allow investors to create implied volatility charts, which may
be the easiest way to determine if the current level of implied volatility
is high, low, or average.
Originally published in the September 2005 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2005, Technical Analysis, Inc.
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